1. Chapter 2
Executive Incentives

2. Chapter overview Potential Managerial Temptations
Types of Executive Compensation
Does Incentive-based Compensation Work in General?
Potential “Incentive” Problems with Incentive-based Compensation
Other Compensation
Crime and Punishment
International Perspective-CEO Compensation Around the World

3. Potential Managerial Temptations
A good manager should put the needs of other stakeholders before his own.
However, if shareholders cannot effectively monitor managers’ behavior, then managers may be tempted to put his needs first, even at the expenses of shareholders.

4. Examples of Self-serving Managerial Actions
Shirking (i.e. not working hard)
Hiring friends
Consuming excessive perks
Building empires
Taking no risks or chances to avoid being fired
Having a short-run horizon if the managers is near retirement

5. Types of Executive Compensation
Base Salary and Bonus
The base salary is usually determined through the benchmarking method.
At the end of every year, CEOs often receive cash bonuses whose size is computed based on the performance of the firm over the past year.
Comparison of awarding bonuses with giving large raises.

6. Types of Executive Compensation (continued)
Stock Option
Executive stock options—the most common form of market-oriented incentive pay.
Stock options give the executive of the firm the incentive to manage the firm.
Stock options are believed to align managers’ goals with shareholders’ goals.
Stock options have asymmetric incentives

7. Stock Option Options and Accounting
Stock option’s favorable tax treatment for both the executive and the company
Accounting cost and economic cost
FAS 123(R)

8. Types of Executive Compensation (continued)
Stock Grants
—An alternative form of long-term incentive compensation that avoids governance failure
Restricted stock does not have asymmetric incentives
Performance shares can be viewed as bonuses for past realized performance.

9. Does Incentive-based Compensation Work in General?
Two ways to examine the efficacy of incentive-based compensation:
ex post evidence, pay-for-performance sensitivity
ex ante evidence

10. Potential “Incentive” Problems with Incentive-based Compensation
Problems with Accounting-Based Incentives
Forego costly research and development that might be beneficial to the firm
Accounting profits may be manipulated
CEOs may place too much focus on manipulating short-term earnings

11. Problems with Stock Option Incentives
CEOs might forego increasing dividends in favor of using the cash to try to increase the stock price
CEOs have a tendency to pick a higher risk business strategy
Stock options may be too far underwater to motivate the manager effectively
CEOs may try to do what they can to time stock price movements to match the time horizons of their stock options

12. Another Problem with Executive Stock Options
Stock prices are affected by company performance but also by many other factors beyond its control
Repricing previously issued options may let options lose their effectiveness

13. Real-World Examples Disney CEO Michael Eisner
—Stock options create the possibility that only short-term value will be created, not long-term value
Management’s Behavior at Xerox
—Managers may manipulate accounting profits

14. Example: Xerox Corporation

15. Expensing Executive Options: An Easy Solution?
Expensing executive option—the cost of stock options issued to employees and executives should be treated as an expense on the granting firm’s financial statements.
Three reasons of expensing executive options:
To have better disclosure and account for the real cost of using options as compensation
To reduce the amount of options executives receive and reduce their total compensation
To reduce CEO’s incentive to time the market

16. Other Compensation
Club membership, financial advisors, luxury cars and chauffeurs, personal travel, etc.
Retirement compensation
Company loan

17. Crime and Punishment
An alternative way to solve the agency-problem is to increase the penalty
The new Sarbanes-Oxley Act

18. International Perspective-CEO Compensation Around the World

19. Summary
Stock and option incentives are believed to solve agency-problem
However, whether or not the incentives work results in much debate
If incentive compensation is imperfect, then monitors are needed.